Hope and glory

As summer slips into autumn, the outlook for the UK is characteristically foggy. Brexit negotiations have been up and down, but if you had to use one word to describe the whole thing it would be omnishambles.

The government has lurched around from signalling the very hardest of Brexits to outlining essentially the status quo and everything in between. It has dropped ministers and negotiation red lines like a tree sheds its leaves. Six months before the deadline for Britain’s departure, no-one on either side of the Channel knows what’s going on. Worryingly, most people seem to have bored of the whole thing and are focusing on other things. Worldwide investors surely have: they have the lowest allocation to UK stocks since Bank of America Merrill Lynch started canvassing them.

And yet. While the UK economy isn’t booming, it seems to be ticking along. Business investment, consumer confidence and house prices are pretty glum. But PMIs are still in growth territory, GDP growth ticked up to 1.3% in the second quarter and UK industrial production easily outdid expectations, rising 1.1% in June compared with a year earlier. Inflation came in 10 basis points higher at 2.5%, right on analysts’ forecasts. The big surprise was retail sales growth, which posted a third consecutive strong month. Britons bought 3.5% more at the shops in July compared with a year earlier, easily eclipsing the 3% expected. Wage growth improved too – the average excluding bonuses rose 20 basis points to 2.9% in the three months to July. Everything else has stayed relatively stable, especially considering the general Brexit fog. At one point, trade-weighted sterling had slumped 1.3% over the month, but it shot up as the month closed out to end effectively flat.

As things stand markets – especially sterling – seem to imply that the UK will suffer the very worst of outcomes. We think the balance of probabilities are likely to produce a fudge. This, along with the significant valuation gap that’s opened up between other advanced economies, is why we counsel our investment managers to retain a slight overweight to UK equities and the FTSE 100 in particular. Any decent news on Brexit should lead overseas investors to return to the UK, and most would probably buy the most liquid UK exposure they can find – the FTSE 100. This buying pressure should mitigate some of the falls that would come from any relief-driven upward move in sterling.
 

Index

1 month

3 months

6 months

1 year

FTSE All-Share

-2.8%

-1.7%

5.6%

4.7%

FTSE 100

-3.3%

-2.1%

5.4%

4.1%

FTSE 250

-0.6%

-0.1%

6.9%

7.3%

FTSE SmallCap

-0.4%

-0.7%

4.2%

5.3%

S&P 500

4.1%

10.2%

14.1%

18.0%

Euro Stoxx

-2.3%

2.1%

3.0%

2.0%

Topix

0.9%

-0.2%

1.3%

7.8%

Shanghai SE

-4.4%

-15.5%

-17.8%

-22.2%

FTSE Emerging

-2.5%

-1.6%

-5.3%

-2.2%

Source: FE Analytics, data sterling total return to 31 August

The free and the brave

In the US, economic data continued its strong run. Small business optimism is at multi-decade highs, retail sales growth is north of 6% and personal income growth is running at roughly 5%. Trade talks continued throughout the month, with a deal struck between Mexico and the US. The concessions demanded to play with America seem too great for Canada, however. The talks are continuing, but it feels half-hearted. Both sides have heavily entrenched and coddled agricultural lobbies that make a deal pretty unlikely. As odd as it sounds, NAFTA – the vehicle of the North American boom of the 1990s and 2000s – is about to die with little more than a murmur.

It seems almost inevitable that the US Federal Reserve will hike rates at the end of September to 2.00-2.25%. That will be the central bank’s third rate rise of the year, at a quicker pace than 2017, and yet it hasn’t done much to dent the American economy. GDP grew 2.9% in the year to 30 June; it roared ahead in the second quarter, with the annualised rate jumping 2 percentage points to 4.2%. The second-quarter rip was driven by consumption, business investment and exports.

Everyone is trying to decide whether the US is “late-cycle” (whatever that means) or not. Some people are fixated on the flattening yield curve: the difference between the 2-year and 10-year Treasury fell to a cycle low of 18.8 basis points in August. When this difference goes negative, i.e. when the 10-year yields less than that 2-year, it almost always signals recession, so it’s a decent measure to keep an eye on. However, just because it’s close to inversion doesn’t mean it will go negative. In the ’90s, this spread remained below 100bps for three and a half years without going below zero. It dipped below for a month or so before heading positive again, and then went for another 18 months before recession. That’s a long time to be wrong.

One place where the mood has been a bit more feverish is emerging markets. For a while now, talking heads have been banging the drum about a dollar liquidity squeeze. Effectively, as the US Federal Reserve tightens rates, the better returns suck money out of higher-risk markets back to the safe haven of the US.  We felt most developing markets were less susceptible to this risk than in the past. Some – like Argentina, Turkey and South Africa – were vulnerable and have been hit hard recently, but overall we thought many other nations should weather the storm relatively well. Of course sometimes the story itself is enough to start a stampede of investors that creates a self-fulfilling prophecy. Especially in today’s increasingly passive world. As it is, we have watched emerging market debt spreads approach and exceed the 400bps we tend to use as a basic “fair value” level. Pockets of value may be appearing in these markets.

Bond Yields

Sovereign 10-year

Aug 31

Jul 31

UK

1.43%

1.33%

US

2.86%

2.96%

Germany

0.33%

0.44%

Italy

3.23%

2.72%

Japan

0.10%

0.06%

Source: Bloomberg